The Political Economy of the Bailout

Tyler keeps wondering whether the bailout (or "bank recapitalization") is going to work. He is asking the wrong questions.

Whether the economy needs a "plan," or whether the plan will help the markets, is beside the point. The plan serves to consolidate power. Four weeks ago, the Fed and the Treasury had far more power than anyone can intelligently use. Still, they came to Congress requesting more power. Then, when the bill was passed, Paulson took even more power than what it sounded like the legislation was giving.

Now, there are rumors that the Democrats plan to re-appoint Paulson as Treasury Secretary. This American Mussolini has captivated Washington by demonstrating the exercise of raw power.

What I call the "suits vs. geeks divide" is the discrepancy between knowledge and power. Knowledge today is increasingly dispersed. Power was already too concentrated in the private sector, with CEO's not understanding their own businesses.

But the knowledge-power discrepancy in the private sector is nothing compared to what exists in the public sector. What do Congressmen understand about the budgets and laws that they are voting on? What do the regulators understand about the consequences of their rulings?

We got into this crisis because power was overly concentrated relative to knowledge. What has been going on for the past several months is more consolidation of power. This is bound to make things worse. Just as Nixon's bureaucrats did not have the knowledge to go along with the power they took when they instituted wage and price controls, the Fed and the Treasury cannot possibly have knowledge that is proportional to the power they currently exercise in financial markets.

Note: I will be on travel from now through the weekend. My writing will be greatly reduced during that time.

Arnold Kling, speaking of the credit crisis and the bailout plans in America, writes:
What I call the “suits vs. geeks divide” is the discrepancy between knowledge and power. Knowledge today is increasingly dispersed. Power was already too ... [Tracked on October 15, 2008 5:49 PM]

I agree that consolidation is the wrong direction. To me the biggest problem has been this notion of "too big to fail". There is a fundamental problem if a company is not allowed to fail and that is what needs to be addressed. There may have been economy of scale reasons why corporations have been big, but (especially in non-physical goods industries) many of the same efficiencies could be gained via well defined interfaces between companies. In a world of lots of medium size financial institutions instead of a few gigantic ones, the suits vs geeks divide would have been much smaller. Plus the markets should weed out the ones making poor choices much sooner.

One way it could be structured would be to have very low capital requirements for small banks and progressively increase capital requirements as banks increase in size. No matter what the mechanism is though, any system that has organizations that are "too big too fail" is flawed.

Except for one post, Tyler has been asking the wrong questions for the past four weeks (and too often you have agreed with him). You have to understand that AFTER Paulson&Bernanke (is Ben still around?) shouted fire on 9-18, there was no alternative but to deal with it--either by showing that they were wrong (an impossible task because they were the only ones to have all the relevant information) or by quickly drawing a good, feasible plan. We're still waiting for this plan.

No they don't. Zoning and land-use regulations restrict supply relative to demand, setting a higher market-clearing price. As long as the regulations stay in place, other things equal, the price will remain at the new level. There's no bubble to burst. A bubble is created by easy money or some other unsustainable demand-boosting intervention.

Back in the old days, when I attended a school that taught the various forms of government, they discussed the idea that feudalism was the outgrowth of local individual who offered physical security against invading hordes-the birth of the castle. Gradually, the security monopolists exacted greater and greater tolls and neighbors became subjects, whose labor, capital and lives, even their children, were subject to royal lien.

Have you ever noticed how government peddles fear as something only it can handle? This has been going on for decades.

1930's An ambitious Democrat is swept to power with promises and trhe villification of the other party. In what was a mere adjunct to the unprecedented expansion government, he creates Fannie Mae.

1977 Another ambitious Democrat is swept to power with promises and the villification of the other party. In an unprecedented expansion government, he signs the "Community Reinvestment Act".

1992 Another ambitious Democrat is swept to power with promises and the villification of the other party. While his plans for the expansion of government are curtailed by the loss of the legislature, his HUD Secreatary begins to make aggressive use of the CRA to push banks to hit quotas for low-income & minority lending.

2008 Another ambitious Democrat is on the verge of being swept to power with promises and the villification of the other party. His background is indicates he is further left than any of his predecesssors and the videos of the kids chanting his name seem a little to much like Munich, Berlin or Nuremberg of the 30's. His plans for the expansion of government are being fueled by groups like ACORN who use their taxpayer largesse to engage in voter fraud. He retains Franklin Raines, the mastermind of the Fannie Mae overstatement of income. If Paulson is Mussolini, then fascism of the most virulent kind is just around the corner.

Actually, they do if you believe in bounded rationality. Rapidly rising home prices masked the rate of foreclosure because homeowners can simply sell for a realized gain. This encouraged more lending, which was more than willing because of the easy money you mentioned. The increased multiple of prices over income encouraged the demand for "creative" loans.

Once the unsustainable growth slowed, foreclosures revealed themselves. Capital was pulled out and prices fell even further. The bloodbath ensued.

The problem with merely blaming easy money is that it doesn't account for the differences between California and Texas. Texas had no bubble and virtually no price drops. According to RealtyTrac data, the default rate in Texas has steadily declined since early 2006.

I have heard no explanation that explains the differences. Unless Texas is immune to greed, witless consumers, easy money, the CRA, Fannie Mae and Freddie Mac, land use regulation explains much.

What I've been wondering for years is how
we get out of this situation.

It seems to me that we need a government
biased to favor the small over the large.

Say, for example, a corporate tax rate indexed
to the gross sales of corporations within
the U.S. Below a certain size there'd be no
tax at all. While at the high end it would be
quite large.

A key question would be how to do this without
giving large foreign corporations an undue advantage
within the U.S. market.

Perhaps all one can do is tax foreign activities
within the U.S. at a rate keyed to their estimated
size. Their likely response, of course, would be to sell
through smaller intermediaries. Whether this is
really a gain for the U.S. is debatable.

But the likely effect on U.S. based companies seems
clearer. They'd have a strong incentive to split into
smaller companies.

This analysis strikes me as over-simplified. Much of the malfeasance in the mortgage market was extremely dispersed. It consisted of individual mortgage brokers, appraisers, borrowers, ratings agencies, and so on all doing the wrong thing. Distribution of power is no solution if the incentives are systematically wrong, and I think you could argue that was the case. Of course, government had a goodly role in setting those incentives, I agree. However, if we agree the system is broken right now, don't we need consolidated power to fix it? Or do we expect markets to spontaneously evolve along more rational lines? I for one would not hold my breath for that. Power corrupts, but how do you remedy corruption without power?

Perhaps the "need" for government bias in taxation would not exist if some of the banks being bailed out (and thus subsidized) had been allowed to fail, they would have diminished, perhaps not in number, as it is unlikely that a bank would end up being completely eliminated, but at least in total capitalization. From what I've heard, the smaller banks in general have not been as leveraged and thus will end up losing less. In other words, if you are right, and banks need to shrink to be more effective, that's exactly what this crisis would be doing. Except the government can't let that happen.

In 2003, under a Republican president thinking mostly about Afghanistan and Iraq, Freddie Mac and Fannie Mae relaxed their requirements on mortgages. Subprime mortgages immediately jumped from 8% to 20% of all new mortgages. Most of the risky mortgages were acquired by Freddie Mac, Fannie Mae, and private financial institutions. The collapse of Freddie Mae, Fannie Mac, and some private financial institutions earlier this year were the first obvious signs of a failing system.

@Greg: I wonder if the ecology of boiler-room mortgage producers could have grown to its recent size without the presence of the relatively few, very large Wall Street firms as upstream consolidators.

For that market to work, there needed to be fast and relatively easy buyers for mortgages in wholesale quantities. The smaller banks generally wouldn't touch the stuff directly, while the larger ones did via CDO/MBS vehicles which as Arnold and others have talked about were a way to work around capital requirements.

In any case as a general principle I do not know of any industry in which "bigger" leads to "smarter." Some industries may genuinely require massive scale simply to function (you're not really going to have 500-person startups building $200mm jumbo jets), but it's less clear that the aggregation of so much financial services, banking, and investment banking under a relatively few roofs has been either as necessary or as beneficial. So far, the most diversified parts of the market (community banks, perhaps PE) seem to have weathered the storm best.

Texas has relatively stricter mortgage lending regulations than most states (certainly much more so than California, Florida and Nevada). This has provided a decent cushion against the direct foreclosure problems, although the regs weren't as tough as the old minimum-20-down standard. No idea if there's any difference in MBS rules here, though.

@David Taht

No, he isn't. Connecticut can have him back.

I also doubt a President can have any significant effect on inter-state job movement without being fairly blatant about things. That would seem to depend much more on state and local regulations, incentives and conditions. Texas has a good mix of industries, from agriculture and refining to high tech, so it can handle segment-wide downturns fairly well.

@bizzle

Given his running mate (six-longest serving senator) I don't think his claims of change would be hurt any further by keeping Paulson around, no matter how bad an idea it is.

As to the main post, consolidation of power has been the trend for most of history. Can't say I find it even remotely surprising, no matter how disgusting it is.

With respect to the comments noting the difference in mortgage defaults between California and Texas, a factor that might contiribute to this difference is that deficiency judgments are not allowed in California for first mortgage loans, while they are allowed in Texas.

This means that in Califonia, a borrower can simply hand the keys to house to its lender and walk away scot free. In contrast in Texas, if the fair market price of the house is less than the remaining amount on the loan, the lender can obtain a judgment for the difference and enforce it against the defaulting borrower.

This means that in California, the borrower has an effectively unfettered put option if the value of the house declines. No wonder then that no down payment mortgages were extremely attractive, since they essentiallly provided all of the up-side potential to the borrower, with the lender bearing all of the down-side. In Texas, the borrower receives the up-side potential, but bears down-side in the event the value of the house declines sufficiently to the point the lender cannot recover the amount of the remaining loan on foreclosure.

The fact this may not have been taken into account by lenders in California (and Florida where I understand defficiency judgments are effectively unavailable), just underscores the point made in an earlier post by Arnold that lenders ignored the put option nature of the loans they were making.

I suspect that we'd have a DJIA under 1,000 and a hefty percentage
of american corporations bankrupt and unemployment levels comparable
to or exceeding the Great Depression at this point if Paulson and
Bernanke hadn't done something. Of course we may still end up there.

Strongly biasing the rules against very large corporations will
not get us out of this disaster we face today, but if we had done this
ten years ago, I doubt we'd be in this mess today. And the same lesson
carries forward to the future.

If all we "learn" from this is the we need more regulation, then
the same crisis or something worse will reoccur down the line.

.
Americans to stupid, to scared, to weak, to enforce the Laws to stop
Financial Disaster.
CEOs Fed Congress make statements they conspired took bribes and unjustly
enrich them self. Corruption believe the few American that will demand
Justice can be over looked or payed off. To many violation to count. Here
Are 2. From CEOs Fed and Congress own mouth
. 1] " Many parties are to blame" Law Dictionary; A conspiracy exist when
the parties use legal means to accomplish an illegal result
2] "The Bail Out is Bribery" Encyclopedia; Any item of value to
influence the actions of an official in discharge of a public or legal duty

Solution ; Unjust Enrichment
Knowledge is immaterial under the law of unjust enrichment
Wed, 4 Jan 2006 17:23:00 -0500
Re: Unjustly enriched executive
"Former HealthSouth Corp. chief executive officer Richard Scrushy has been
ordered by a judge to repay his former company more than $47.8 million in
bonuses, according to published reports. ... Judge Allwin E. Horn III of
Jefferson County Circuit Court in Birmingham, who made the ruling as part of
a summary judgment in a shareholder lawsuit, determined that Scrushy is not
entitled to the payments whether or not he participated in the fraud or knew
about the scheme."
Prosecution evidence
Fed lowers Interest to prop Fannie and Freddie
2001 to mid 2003 the Federal Reserve lowered its interest rates 13 times,
from 6.25 to 1.00% overnight rate averaged 0.68% June 2004,
the Federal Reserve System target interest rate continued to do so 17
straight times
In March 2006, the Federal Reserve ceased to make public M3, arguably the
most reliable means of measuring the money supply.
Fed declared that the costs of collecting this data outweighed the benefits
Here's the kicker
The Fed needed to increase rates not lower them
Quote". overnight overdrafts (more than three occurrences in any 12-month
period), the overnight overdraft rate increases by one percentage point for
each additional occurrence."
American Demand Law Enforcement and Remove ,the Corrupt CEOs, Fed,
Congress
.Recover $500+B, Honor and make corruption look stupid.
American have no choice but to take the Law in there own Hands or the
corrupt have take control of America
Rem; Congress did not fail they scammed,
Rem; Congress had many red flags about the credit problem
Use the war to decoy American focus
Congress , Falsely accused, made statements of treason and stopped much
funding to protect our Military.
Congress disrespected the position they held to the point of treason.
The rule ; one is judged on how they have judged then they need to go to
prison for life and hell for eternity.
Rem; Corrupt CEOs, Fed and Congress believe they are above the law and
Americans to stupid, to scared, to weak to enforce the law..

Blogging software: Powered by Movable Type 4.2.1.
Pictures courtesy of the authors.
All opinions expressed on EconLog reflect those of the author or individual commenters, and do
not necessarily represent the views or positions of the Library of
Economics and Liberty (Econlib) website or its owner, Liberty Fund,
Inc.

The cuneiform inscription in the Liberty Fund logo is the
earliest-known written appearance of the word
"freedom" (amagi), or "liberty." It
is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.